The Inflated Value of Stock-Drop Class Actions

JURIST Guest Columnist Richard Booth of Villanova University School of Law says that courts should stop certifying securities fraud class actions, as they compound the loss to stockholders and other methods could be utilized to deter corporate fraud and more effectively provide restitution to all affected stockholders...

Since 2005, the Supreme Court has rendered eight decisionstwo just this yearin securities fraud class actions. These suits were brought on behalf of investors who had bought stocks at prices allegedly inflated due to the false corporate statements. All of these cases arose under Securities and Exchange Commission (SEC) Rule 10b-5, the catchall anti-fraud rule. These do not include cases involving initial public offerings, insider trading or any other form of securities fraud. Rather, in each case, disappointed stock buyers sought compensation from the issuer company for losses suffered due to sudden decreases in the stock price after the false statements were revealed.

The number of stock-drop cases taken by the Court is remarkable because each year it decides fewer than one hundred cases. However, this follows the Court's practice of choosing cases where the lower courts are confused about the law, as is the case in securities fraud class actions. The Court has ruled that in these cases only the affected stock buyers have standing to sue. Since the company (or its insurer) pays in the event of a buyer's successful suit, it is the other stockholders who effectively bear the cost. In other words, stockholders pay buyers, but those who sold their stock before being affected by the stock-drop keep their gains.

This circularity is bad enough, but it gets worse. Since the company pays, stockholders effectively lose twicefirst from the decline in stock value because of the bad news itself, and second from feedbackthe further decline in stock price attributable to the payout to the buyers. Moreover, because the prospect of a payout increases the amount of loss, it increases the amount of the class claim, which further increases the loss, and so forth. Mercifully, the process reaches a mathematical limit depending on the size of the plaintiff class. In addition, the stock price may fall further because of securities litigation costs, possible fines and due to the reluctance of future investors.

For example, suppose that a share of Vandelay Corporation trades at $20 on expected earnings of $2 per share. Unbeknownst to the market, a major customer has cancelled a contract, and earnings are instead likely to be $1.50 per share. Nevertheless, the CEO reassures the market that business is good. In the absence of the cover-up, one would expect stock price to fall from $20 to $15 when the truth comes out. However, because management lied to the market and the company will likely have to pay a class action settlement, the stock price falls further, perhaps to $10. Some of the additional decrease may also be attributable to the market's perception that Vandelay is riskier than previously thought.

In a securities fraud class action, buyers can individually recover their entire loss$10 per shareassuming of course that they prove their case. Except for the first $5 of loss, it is the corporation that suffers the harm. One would think that the corporation (if anyone) should recover for the benefit of all the stockholders. Instead, individual buyers recover, and the remaining stockholders effectively lose twice.

The first $5 of loss, which affects all stockholders, is going to happenfraud or no fraud. Thus, it is not really a recoverable loss. Although one might try to justify securities fraud class actions as a form of investor insurance, most investors are effectively insured anyway because they are well diversified by virtue of investing through institutions such as mutual funds and pension plans that hold more than two-thirds of all stock. A diversified investor is just as likely to gain from the sale of an overpriced stock as to lose from the purchase of one.

Although an undiversified investor might be happy to forgo some return as a fee for such insurance, the costs of securities litigation, including attorney fees and management distraction, are a deadweight loss that serves only to reduce aggregate investor return. The bottom line is that a securities fraud class action perpetuates the loss that it seeks to recover, with a remainder that is not really a loss at all.

More importantly, diversified investors lose when they are mere holders of a fraud-affected stockwhich is the case for most affected investors. Most investment advisers agree that a buy-and-hold strategy makes the most sense for most investors. However, consider how a diversified buy-and-hold investor might fare in a class action. If most, but not all, of the investor's shares were purchased before the false statement, the investor would prefer that the class action simply be dismissed. To be sure, the law provides that one can always opt out of a class action. It does no good for the investor to opt out though, since this would forgo any recovery at all. Thus, the investor will reluctantly file a claim in the class action despite his preference for the action's dismissal. The cure is worse than the disease.

Federal securities law is supposed to serve the interests of reasonable investors. Given that reasonable investors diversify and follow a buy-and-hold strategy, it is difficult to see why the law provides a class action remedy in such circumstances. The law requires that the plaintiff in a class action must fairly and adequately represent the interests of the class. No one can do so if most of the class would oppose the action. Accordingly, the courts should decline to certify most securities fraud actions as class actions. The obvious retort is that in the absence of a class action remedy, there would be no effective deterrent to this type of securities fraud because the SEC does not have the resources to pursue every individual claim in an enforcement action. There are several responses to this.

First, since class actions compensate investors for harms that can be hedged away with diversification, and because class actions cause the stock price to fall more than it otherwise would, class actions constitute excessive deterrence for securities fraud. Although one might argue that we should deter fraud however we can, too much deterrence makes managers reluctant to speak at all. Presumably, investors want as much information as they can get, and they are willing to accept an occasional mistake if it means more information.

Second, there are other forms of deterrence. As noted above, investors may suffer a genuine loss if the value of the corporation is reduced by civil fines and other expenses of litigation or an increase in the cost of capital. These losses are suffered by all of the stockholdersnot just those who stand to recover. Thus, the corporation has a claim for compensation against the individual wrongdoers causing the original stock-drop through false statements. If the corporation declines to sue, a stockholder may sue derivatively on behalf of the corporation. If the action is successful, the corporation recovers, and stockholders are effectively compensated for that portion of their loss without causing further losses due to feedback. The only element of loss that remains is the loss that was going to happen anyway. However, a diversified investor is protected against that sort of loss. Thus, if the corporation recovers, the stockholders are restored to where they would have been in the absence of fraud. Herein lies yet another reason why the courts should decline to certify securities fraud class actions. The law requires that a class action be superior to other methods of fairly and efficiently adjudicating the controversy. There is no doubt that a derivative action is the superior way to litigate such cases.

The mystery is why stock-drop actions have survived at all. Legal scholars have cooked up all sorts of reasons why they might make sense. The fact remains that stock-drop actions make sense only for the lawyers by increasing the size of the claim and the corresponding attorney fees. So why is it that defendant corporations do not argue that they should recover from the individual wrongdoers? One obvious answer is that a derivative action pits the corporation against its own officers. In a class action, corporation and management can circle the wagons against a common foe. Moreover, insurance may not cover a claim by the corporation against its own officers.

Still, none of this explains why an index fund would not come forward to oppose class certification and argue that a derivative action is a superior remedy. The implication for an index fundwhich trades primarily for purposes of portfolio balancingis that the fund may recoup its losses to the extent that it is a buyer of a fraud-affected stock but it will lose to the extent that it is a holder of the same stock. In most cases, an index fund will be a holder as to many more shares than the number of shares bought during the fraud period. It may be that when a fund receives a big settlement check, no one thinks to ask how much has been lost in the bargain.

Ironically, the Supreme Court recently ruled in Dukes v. Wal-Mart Stores that it is inappropriate in a class action for injunctive relief to award damages to individual class members. A derivative action is in fact a class action for injunctive relief, compelling the corporation to sue. It is more than a procedural nicety in a securities fraud action that recovery should go to the corporation and not individual buyers. Not only does the corporation pay when buyers recover, but the corporation is also denied any recovery for the losses it suffers. It is time to clean up the mess of securities fraud class actions, but it is not clear that anyone is motivated to do the job.

Richard Booth is the Martin G. McGuinn Chair in Business Law at Villanova University School of Law. He teaches corporate finance, business planning and securities litigation. His recent research has focused on the impact of investor diversification on a range of corporate issues arising in connection with securities trading, from broker-dealer fraud to program trading.

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